A period of increasing rates is great for preferred stock buyers - the higher coupons that come with increasing rates puts more money in your pocket. But as rates go up, prices for older, lower payers go down which can be bad news for those intending on selling their previously purchased preferred stock shares.
With the Fed increasing the federal funds rate twice over the last five months - with additional increases predicted to be on the horizon - the technique that I describe here allows preferred stock investors to turn the known inverse relationship between rates and prices to your advantage during a prior of increasing interest rates.
During periods of upward pressure on interest rates, we often see what I refer to as "upgrade" opportunities. Upgrading takes advantage of market price disparities that tend to occur during such periods.
Increase income and cash
Upgrading involves selling a lower-paying preferred stock that you own and using the proceeds to buy a higher payer of similar quality, keeping pace with increasing rates, but for a lower price. The result is that (1) your dividend income will increase and (2) you will have cash left over.
There are literally dozens of such opportunities with U.S.-traded preferred stocks right now.
All you need is a list of preferred stocks that are similar to a lower payer that you own, sorted by their current market price. I will use data from April 26 to illustrate how upgrading a lower-paying preferred stock is done.
Example: Wells Fargo's Series R Preferred Stock (WFC-R)
Let's say that I own WFC-R from Wells Fargo (NYSE:WFC), which I purchased at par ($25) back when WFC-R was issued in 2013.
WFC-R is a non-cumulative, call-protected, investment grade traditional preferred stock currently paying a fixed quarterly dividend of 6.625 percent that qualifies for favorable tax treatment (Qualified Dividend Income - QDI).
First, we need a list of preferred stocks that are very similar to WFC-R. Preferred stocks have a variety of characteristics so I want to be sure that I am comparing apples to apples as much as practical. Here is how I configured the search engine's 25 preferred stock characteristics to find such a list:
The resulting preferred stocks are all very similar to WFC-R: call-protected for several years, are not convertible to any other type of security, have a $25 par value, are currently paying a fixed-rate dividend, pay tax-advantaged (QDI) quarterly dividends, are issued by U.S. companies and offer a Moody's investment grade rating.
Of the 954 preferred stocks and Exchange-Traded Debt Securities currently trading on U.S. stock exchanges, 83 meet the search results seen above.
Of these 83, I will use 10 here as examples to illustrate how to upgrade a lower-paying preferred stock. These preferred stocks are all very similar and are issued by Wells Fargo, US Bancorp (NYSE:USB), KeyCorp (NYSE:KEY), Edison International/Southern California Edison (NYSE:EIX), JPMorgan (NYSE:JPM), Allstate (NYSE:ALL), First Republic Bank (NYSE:FRC) and Bank of America (NYSE:BAC).
In this list of 10 preferred stocks, there are 23 upgrade opportunities. Can you spot them?
Here's the trick
A table with no upgrade candidates, once sorted by their current market price, highest to lowest, will also show the dividend rates in sorted order, highest to lowest.
But notice that that is not the case here. The Div Rate column starts out okay-6.625 percent down to 6.500 percent, then down to 6.125 percent and on to SCE-H's 5.750 percent; so far, so good. But then, after SCE-H's 5.750 percent, the next Div Rate is higher. We go from SCE-H's 5.750 percent up to JPM-B's 6.700 percent.
Bingo. WFC-R for JPM-B is our first upgrade candidate. And all you need is a list of preferred stocks sorted by market price (highest to lowest) to spot them. Keep an eye on the above table and I will walk you through the upgrade of WFC-R to JPM-B.
If you own shares of WFC-R, which pays 6.625 percent, you could sell them for $29.73 and use the proceeds to buy JPM-B at $27.70. JPM-B pays a higher 6.700 percent dividend rate, increasing your dividend income by 0.075 percent, plus you will have $2.03 per share in cash left over.
Notice that in this upgrade you are paying $27.70 for JPM-B.
Preferred stock investors should avoid purchasing shares for a market price above the security's $25 par value. Purchasing JPM-B at $27.70 exposes you to a potential capital loss of $2.70 per share in the event that JP Morgan calls JPM-B downstream.
But what if you were reimbursed for any potential future capital loss in advance? Remember, you have $4.73 per share in your pocket right now from your sale of WFC-R (since you originally paid $25 per share for your WFC-R shares). That's more than enough to reimburse the $2.70 capital loss in the event that JP Morgan calls JPM-B someday.
You have already been reimbursed for any future capital loss on the JPM-B shares and will still have $2.03 per share in cash left over, even if they do so.
Results - something for every investor
Here are the 23 upgrade opportunities from the above list of 10 examples and the results from each.
Look down the Results columns (far right) and notice how different upgrades can appeal to different investors.
Those seeking to maximize their cash position would focus on upgrade number 4 since it improves their cash position by a whopping $2.56 per share.
Alternatively, investors looking to improve their risk profile would favor upgrade #13 since it trades in a Baa3 rated security (KEY-I) for one with a higher Baa2 rating (ALL-E).
Lastly, investors looking to maximize their dividend income would find upgrade number 16 appealing since it improves dividend income by 0.875 percent.
Each of these 23 upgrades involves trading in a lower-paying preferred stock for a very similar higher-paying security and each opportunity leaves you with cash left over.
Using this simple technique can provide preferred stock investors with a way to make very beneficial adjustments to their income portfolio during a period of increasing interest rates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and Exchange-Traded Debt securities used for this article.